Liongate Capital Management was named the Fund of Hedge Funds Leader of the Year in 2009 by Institutional Investor News, and in 2008, a year not generally kind to funds of funds, its flagship Liongate Multi-Strategy Fund was down only 9.99%. The London-based firm, with $2.8 billion under management and a due diligence process that has been described as “institutional quality,” has also been one of the loudest voices in the chorus calling for greater transparency in the hedge fund industry. Senior reporter Mary Campbell recently spoke with Managing Director Jeff Holland about transparency, regulation and the role of the institutional investor in the industry, among other things.

How do you feel about EU plans to increase regulation of the European hedge fund industry?

I guess our view, broadly, on regulation is that regulation is something that we’re generally pretty supportive of…our view is that sensible regulation is good for everyone, it’s good for investors and it’s good for the hedge fund industry in itself. I think good regulation really should be designed to meet two objectives: one, it should protect against the risk of systemic crisis caused by a large hedge fund… that would be an LTCM [Long-Term Capital Management] scenario, but I think LTCM is really the only example of a hedge fund that had to be bailed out because of concern that its imminent failure would cause a systemic crisis. And in the end this bailout was funded privately and not by the government. And as we know, during the financial crisis, it was the banks and not the hedge funds that caused systemic problems.

The second objective of regulation should be to protect investors and that would be to protect investors against the Madoff-type scenario. If regulation is designed in a sensible way, so that hedge funds aren’t overly burdened by regulation, then I think both of those objectives can be met, and if both of these objectives are met, then it’s a good thing for everyone. And it’s a good thing for the industry, because you know, at Liongate we didn’t invest in Madoff, for example, but we still felt the effects of those funds that didn’t do proper due diligence, and we were sort of tarred by that brush, which isn’t good for anyone.

I think there are a lot of things in the regulation that’s proposed [in Europe] that are good. In some areas it lacks clarity, so you know the devil will be in the details. In areas like use of leverage…the spirit of that rule, for example, is clear; how it will actually be implemented is less clear. As an objective, going back to the two goals of regulation that I mentioned earlier, I think sensible limitation on leverage for hedge funds, as with banks, is good to limit systemic risk. And so I think those sort of rules are good if they’re defined in a suitable way. I think that the concern that the hedge fund industry has is that there hasn’t been much cooperation between regulators and investors on the formulation of the draft proposals and to a large extent the drivers of the regulation seem to be fairly political.

And unfortunately, the public doesn’t have a good understanding of what the hedge fund industry is all about. The reality is, the industry is one that is an innovation on long-only investing and hedge funds, when they’re run properly, are conservative vehicles that offer better risk-adjusted return for investors. That’s something that European investors – you know, pension funds in the UK and the Netherlands and elsewhere – desperately need because they’re underfunded. They need access to those more sophisticated tools in investing and I guess if regulation isn’t sensible, it only hurts the pensioners of Europe and that would be unfortunate.

How do you feel about the proposed restrictions on offshore funds?

We’ve been following it very closely and over the last few days I think it has become apparent that that limitation is likely to be dropped, which is a good thing, and it appears likely to be replaced with, from what we understand, a test of four criteria, so that if a fund is not based in the EU: [one], the local jurisdiction needs to have a cooperation agreement between their domestic regulators and the EU; two, that they’re not blacklisted for the failure to prevent money laundering or terrorist financing; three, that they have a tax treaty with Europe; and four, that they allow reciprocal access to their markets for European products.

So that criteria, I think, is a lot more sensible because, what was drafted before, I think the US in particular saw it as quite protectionist. If it’s revised along these lines, which is what we understand is likely to happen, I think it’s much more sensible. And in reality, I don’t think anyone thought that that restriction would find its way into the final version because it is so unworkable. I think the surprise is that it found its way to this point without having been dropped. I think if the regulators were speaking with large pension funds in Europe and the industry in a more collaborative way, that restriction would have been dropped from the draft ages ago. But it just goes to show that the drafting has been fairly politically driven.

Does Europe represent a big market for US-based hedge funds?

I would say Europe does represent a substantial market for US-based hedge funds and in fact, if you look at the location of those managers, the predominance of them are still located in the States, followed by London. Hedge fund managers typically come from the proprietary trading desks of large banks and those operations are in New York and in London, predominantly, so it's no surprise that managers are located in those places. Most of the large US-based managers have client development offices in Europe, and European institutions are a key market for them. And since most managers are based in the States, European pension savers need access to the best-of-breed managers located there.

It’s actually quite complicated for a fund manager to market a fund in the EU, isn’t it? There’s no blanket approval for the entire bloc, you have to meet requirements for each country, is that right?

That’s right, at the moment, the limitations for investors are country specific, with differing private placement regimes, and they’ll vary, whether the investor is institutional or high-net-worth retail. And it varies from country to country, some countries in the EU have allowed hedge fund investment for their institutional pension funds for a long time, Scandinavian countries, for example, have been heavy users of hedge funds for a long time. Other countries, like Spain, only more recently allowed pension funds to invest into hedge funds and other countries, like Germany, have allowed pension funds and insurance companies to invest for some time but under certain restrictions…But it varies by country to country.

[Marketing hedge funds] means understanding the local regulations and what limitations there are. Usually it’s the case that approval isn’t required by the local regulator unless you’re wanting to approach certain types of retail investors, although in Austria, for example, you have to provide certain tax filings to the regulator and so your fund has to have a certain tax status for institutional clients to invest. So it’s not regulatory approval per se, but it’s a certain tax-filing requirement or otherwise they won’t invest.

Speaking of pension funds, do you think, as they become bigger investors in hedge funds, they will change the way hedge funds do business, due to their concerns about things like transparency and liquidity?

Yes, I do, in fact we’re seeing that already and since the financial crisis I think institutional investors have been more demanding. Investors are demanding transparency because they want to understand what’s in the portfolio, what they’re being exposed to, and one of their concerns and why they’re wanting to understand what’s in the portfolio is that they want to understand what the liquidity risks are…. Investors were really angered during the crisis when a lot of their hedge fund managers said they couldn’t have cash back because their investments weren’t liquid. And many managers had effectively mismatched the liquidity they were offering to investors. I think at Liongate we were one of only a couple of fund of hedge fund managers in Europe, to my knowledge, that didn’t restrict liquidity for our investors at all – we didn’t change our redemption terms or side-pocket any investments. And our investors who wanted to take their cash back, we were able to give it back to them without having to restrict that at all. But we were very much an exception in doing that.

What would you say are the advantages to institutional investors of investing in a fund of hedge funds rather than directly in hedge funds?

I think hedge funds are advanced investments and they require a higher level of understanding. Our role is to know what the risks are in individual hedge fund managers and as well how to combine them into a portfolio and at Liongate we have a team of 50 people whose sole focus is to look at hedge funds and to understand them. For pension funds to try to do that directly, to make hedge fund investments directly, I think it’s only an option for the largest, most sophisticated of pension funds. Otherwise, I think it’s best to leave it to the fund of fund manager to make those selections and it’s worth the fees in the end because the cost of investing in a blowout creates too much headline risk for pension funds. So unless they are very large and sophisticated and have large research teams, I think for them it’s worth the cost [to be] able to transfer some of the fiduciary cost of fund selection to the fund of funds manager.

That’s the model. Unfortunately, not all fund of funds performed well during the financial crisis. You know, some invested in Madoff, for example, and there’s no excuse for an institutional client to have invested in Madoff. If you did proper due diligence you would not have gone anywhere near Madoff. Those funds of funds are now going out of business, and they should, and I think what are left are firms that have demonstrated that they are able to do proper due diligence and manager selection and so I think the fund of fund industry has matured – the weaker players are now flushed out – and it’s a better, stronger industry for having gone through this period.

When you’re considering an investment in a hedge fund, does the manager play a big role? Are you more interested in past performance? What exactly do you look for?

For Liongate, most of our fund of funds are multi-strategy, so we’re looking at managers across different strategies. I think it’s an important question because I think fund of funds should have the sophistication to avoid chasing performance and should select managers that really are the best. At Liongate, we have more of a top-down dynamic approach to our portfolios, so we’re trying to select managers who are positioned to perform well within the current macro environment and to avoid managers or strategies where we feel there’s a lot of risk. And in the past, you know, we avoided issues in credit because we were net short credit in our portfolios from the beginning of 2007 and we reduced almost all of our equity exposure by the beginning of 2008, so the performance of our flagship fund in 2008 was much better than our peers – we were down by less than 10% in a year when most fund of funds were down 20-22% and we’ve annualized at about 10% in our flagship fund since the inception of that portfolio in 2004.

I think the risk of institutional clients who try to approach single managers directly is that there’s a risk that they chase performance. We’re seeing now that a lot of flows are going into macro funds that performed in 2008, and some of the large macro shops have been the beneficiaries of a lot of direct allocations from institutional funds. But macro funds don’t always perform well, they generally did in 2008 and they were liquid investments, but there are certain market environments that aren’t favorable for macro funds and macro funds also tend to be more highly volatile, so I do wonder to some extent whether pension funds, in making those allocations, aren’t chasing performance.

Editor's Note

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